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Family Savings Trust Income Tax Planning

The first issue to be considered in creating the Family Savings Trust is the income tax treatment of the trust. Who do we want to be taxable on the trust’s income? Do we want the income included on the parents’ tax returns or perhaps the children’s returns or some other family member? Sometimes we might want to have the income taxed to a different entity entirely, maybe a corporation or an LLC.

Grantor vs. Non-Grantor Trusts

The ability to direct the income tax consequences of the trust often depends on whether it is designed as a Grantor Trust or a Non-Grantor Trust. The provisions of Sections 671-679 of the Internal Revenue Code specify the terms of whether the trust is a Grantor Trust or not, depending upon the extent of the powers retained by the trustors. The difference is that when a trust is treated as a Grantor Trust, all of the income is required to be included on the tax return of the person(s) who establishes the trust.

For example, let’s say the assets of the Family Savings Trust consist of a 98 percent limited partnership interest in a Family Limited Partnership and the FLP holds investments which generate $100,000 in income. The Family Savings Trust would have $98,000 of income, and the question of who reports and pays tax on that amount depends on whether the FST is considered a Grantor Trust or a Non-Grantor Trust. If it is a Grantor Trust, then the FST is ignored for federal tax purposes and all of its income is reported on the parents’ tax return. If the FST is a Non-Grantor Trust, then the income is included on the tax return of the FST or, if distributed, on the return of the beneficiaries.

Shifting Income to Lower Brackets

The choice of who we want to be taxed on the income is often based on whether an overall tax savings can be generated. When a trust beneficiary is in a substantially lower tax bracket, because of lower earnings, it sometimes makes sense to shift the income to that beneficiary. As Congress considers whether to increase the tax rate on high income earners, the savings which result from income shifting from the highest bracket to a lower bracket can produce substantial savings. If the Bush tax cuts expire in 2011, a shift of $35,000 of income from the proposed top bracket of 39.6 percent to the lowest bracket (0 percent to 15 percent) would produce an absolute tax savings of about $10,000. There may be other circumstances where income can be shifted to a particular individual or entity to take advantage of large current or carry-over tax losses.

Tax savings from income shifting may also arise if the trust or a beneficiary is domiciled in a state with lower personal income tax rates than the parents’ home state. Many of the “trust friendly” states, such as Nevada, Alaska, Delaware, and South Dakota (plus, Florida, Texas, Washington, and Wyoming) have no state income tax and an obvious advantage is gained if income is shifted from a high tax state to a zero tax state. The ability to shift income may be particularly important to those who anticipate a large capital gain on a future sale of stock in a private or public company. In some circumstances, it is possible to avoid a state capital gains tax by careful planning to domicile a trust in a zero or low tax state.

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